Ask the Advisor: Using Equity Compensation in Early Stage Companies

Ask the Advisor is a weekly PaySimple column featuring reader-submitted small business questions answered by our panel of business professionals. If you would like to submit a question, or become a PaySimple business advisor, please read the information at the bottom of this article.

This week’s question is answered by Matthew Uretsky, Associate, of the SorinRand Law Firm.

Question:

“We would like to attract qualified employees, contractors and advisors to work with our company, but lack the cash resources to offer large salary and benefit packages. How can we appeal to, and retain, skilled persons in the early stages of our company’s development?”

Answer:

You’ve identified probably one of the most critical issues for start-up companies: recruiting and retaining talented employees. Start-ups need to attract high quality individuals to build and grow the business, but cash is a precious commodity for most start-ups, often more appropriately directed toward research and development and marketing efforts. Base salaries at start-ups are generally lower than what qualified employees might command at more established companies, and early-stage businesses are reluctant to provide employees with benefits such as health insurance or retirement packages. The primary method by which start-ups attract quality talent is through equity compensation.

Equity compensation is non-cash consideration (usually in the form of stock or the right to purchase stock at a later date) that represents an ownership (or potential ownership) interest in the company. Compensating employees with stock allows the company to conserve cash for research and development and other working capital needs, while aligning employees interests with those of the shareholders. In order to grant equity to employees, the company and its shareholders usually first adopt an equity incentive plan which provides the framework for issuances of various types of stock incentives.

Equity compensation can take a variety of forms, but the most common types of grants to employees in start-ups are stock options and restricted stock. There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). Generally speaking, ISOs, which can only be granted to company employees and must be granted with an exercise price no less than grant date fair market value, enjoy more favorable tax treatment for option holders than do NQSOs. Both types of stock options represent a right to purchase shares of the company’s stock at a predetermined price (known as the exercise price). The right to exercise the option and purchase shares of the company’s stock generally accrues, or “vests,” over a period of time, which creates an incentive for the employee to remain with the company and increase the company’s value. It is important to remember that option holders are not stockholders; option holders only become stockholders upon exercise of their options, and only to the extent of the number of options exercised.

Alternatively, start-ups and early-stage companies often compensate their employees with restricted stock. In contrast to stock option holders, recipients of restricted stock become the owner of the stock, and can therefore vote the shares and exercise all other rights of stockholders, on the date of the restricted stock grant. Restricted stock is often subject to a “repurchase right,” which provides the company the right to repurchase all or a portion of the stock upon the termination of the employee’s engagement with the company. The repurchase right lapses over time, in much the same way that stock options vest according to a preset schedule.

Equity compensation is a critical aspect of employee recruitment and retention for start-ups and early-stage companies. Due to the multitude of legal, tax and accounting concerns involved with equity compensation, we recommend that you seek legal and accounting advice before implementing an equity compensation plan. We are happy to advise your company regarding these and other compensation issues.

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Hello world! My name is Patrick Jones and I'm a search engine optimization associate at PaySimple. When I'm not crafting witty blog posts and tweaking AdWords campaigns here at PaySimple in downtown Denver, you can find me trout fishing, paragliding, mountain biking, or tinkering with my fitness marketing project.
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